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Determination of Income and Employment: Complete Classical Model

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The complete classical model of income and employment determination in an economy in Fig. 3.7. In panel (a) of this figure labour market equilibrium is shown wherein it will be seen that the intersection of demand for and supply of labour determines the real wage rate (W0/P0 ).

At this equilibrium real wage rate the amount of labour employed is N1; and, as explained above, this is full employment level. As depicted in panel (b) of the figure this full employment level of labour N1 produces Y1 level of output (or income).

In panel (c) of Figure 3.7 we have drawn 45° line that is used to transfer the level of output on the vertical axis in panel (b) to the horizontal axis of panel (c). In panel (d) we have shown the determination of price level through intersection of the curves of aggregate demand for and aggregate supply of output, as explained by the quantity theory of money. In the classical theory, aggregate supply curve AS is a vertical straight line at full-employment level of output YF.

Thus, given constant velocity of money V, the quantity of money M0 will determine the expenditure or aggregate demand equal to M0V according to which aggregate demand curve (with flexible prices) is AD0. It will be seen from panel (d) of Fig. 3.7 that intersection of vertical aggregate supply curve AS at fully-employment level output YF and aggregate demand curve AD0 determines the price level P0. With price level at P0, the money wage rate is W0 so that W0/P0 is the real wage rate as determined by the intersection of demand for and supply of labour [see panel (a) of Fig. 3.7].

Now, a relevant question is how this equilibrium level of real wage rate, prices, employment and output (income) will change following the increase in the quantity of money. Suppose the quantity of money increases from M0 to M1 with the given capital stock (as we are considering the short-run case) and the labour force being already fully employed, the output cannot increase. Therefore, as depicted in panel (d) following the increase in money supply to M1, aggregate demand or expenditure will increase to M1 V and thereby causing aggregate demand curve to shift to AD1. As a result, price level rises from P0 to P1.

However, as explained above, with the given money wage rate W0, the rise in price level from P0 to P1 will cause a fall in real wage rate. As will be seen from panel (a), with the rise in price level to P1 real wage rate falls to W0/P1.

This will cause temporary disequilibrium in the labour market. At the lower real wage rate W0/P1, more labour is demanded than is supplied. Given the competition among the firms, this excess demand for labour will cause the money wage rate to rise to W1 level so that the real wage is bid up to the original level W1/P1 = W0/P0.

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With the real wage rate being quickly restored to the original level, employment of labour NF and total output or income YF will remain unaffected. To sum up, the result of increase in money supply is to raise money wages and prices in equal proportion, leaving real wages, employment and output unaffected. The results of decrease in money supply can be similarly worked out.